Topic: Corporate Governance and Firm Value Impact of 2002 Governance Rules

Introduction and Literature Review of the topic

Presented To, Sir, kashif Khursheed

Presented By, Jahanzaib Yousaf Muhammad Sohaib Muhammad Ihsaan

Department of Management Sciences National University of Modern Languages-Islamabad Campus Faisalabad

Introduction:
Corporate governance is a burning issue today in business world especially in the life of listed corporations. The creation of agency problem regarding management and controlling issues laid down the equilibrium of the major controlling, handling and beneficiary activities of lifecycle of an organization. This sought to avoid these types of conflicts of interests between stakeholders especially between shareholders and management through set of specific rules and regulation setting a major impact on firms returns and financial, operational and managerial performance initializing from investors satisfaction. The investors confidence and trust together with protection of rights of all stakeholders becomes more demanding in new era belonging upon ethical background and stakeholders perspectives, exactly starting from major corporate scandals of business world especially in USA. The evolution of corporate governance is a step towards the good governance and corporate responsibilities of corporations. The empirical evidences through research on corporate governance show that different participants in the affairs of an organization have different strengths to protect their rights. The shareholders demand more and more returns against their investments while the executives like directors; sr. managers (CEO, CFO, MD) want to give small portion of the returns of the organization to shareholders and same time they want heavy compensation like high salaries, bonuses and other benefits. This led to agency problems and to corporate scandals. Meanwhile the bankruptcy cases and publically awareness of corporate scandals damaged the investors trusts and corporation went into failure and ultimately this affected the firm value. After that the whole picture was trapped and some codes of corporate governance were introduced to have a balance in governing, controlling and operating the fair view of corporate affairs. Sarbanes Oxley Act 2002 is a major example for step towards corporate regulation and many other codes of corporate governance were issued by governing authorities and Govt. The basic terminology of the title is as under, Corporate Governance Set of activities, tools and practices which are followed to direct and control the affairs of a corporate body in order to protect the rights of all stakeholders (Safdar A Butt)
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Firm value The financial performance and financial outcomes in terms of returns of an organization (Barley) Huge research work was done upon the relationship between corporate governance issues like executive compensation, structure of boards of directors, injection of independent none executive director, related party transaction, rights of all stakeholders and firm value. The empirical studied showed that all these issues have direct relation with firm value and the implications & adaptations of codes of corporate governance can increase or decrease the value of a corporation. Different authors gave different opinions about corporate governance issues and firm value depending upon several types of variables. Then as a result of these studies the evolution of set of regulation like Cadbury report, Sarbanes Oxley Act 2002, OECD principles etc. Took place at that time. There are several variables which contribute to affect the firm value in context of corporate governance while applying code of governance. These variables are as Some research studies showed that the firm value depends upon the adaptations of these codes of corporate governance more compliance firms got more returns and less compliant firms got less returns. This study also showed that the size of a firm also matter while following these rules and ultimately affect the firm value (Vithi Chhaochharia and Grinstein 2008). The provisions regarding corporate governance are correlated with firm value. As the provisions are entrenched the firm value increased which showed that they are positively correlated. But there are some provisions out of 24 provisions given by (IRRC) institutional investors research center which are negatively correlated based upon the results of experiments of provisions index ( bundle of provisions). But actually the correlation between returns and governance in a given period of time has several interpretations (John M. Olin 2002). The separation of ownership and control generated the strong agency problems which laid down the way to impact on firm value and it was monitored that the formal and informal contracts between parties cant control the aggressiveness of agency problem then the governance rules were seemed essential for corporate governance (Stuart Gillin 2003). The research also tells that the
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most of financial Statements frauds are connected with executive compensation package. Most of frauds are due to higher proportion of inside members in the board of directors. The injection of outside directors in the board reduces the financial statements frauds. These outside members of boards are usually called independent none executive directors. The inside members cant show the transparency of financial statements accurately and the presence of audit committee does not affect the frauds ratio. The outside board members having huge compensation cant attach with top management for manipulation of financial statements but they can maximum control over top management. The lower compensation package can divert the control into greed and so they can attach with top management to get financial benefits and so to manipulate the financial record (Benin 2006). The role of top management if much significant in corporate governance in order to compliance the code of corporate conducts. As top management is dealing directly with resources of the firm so its importance and basic .The CEO can influence the management team towards achieving the goals and to comply with governing codes. The severance pay of CEO is another issue in this regard (Andres

Almazan 2003). The board structures also play an important role while determining the firm value towards corporate governance. The presence of independent none executive directors is satisfying for investors and shareholders. The dual role of board of directors is necessary like monitoring and advisory role of board but sometimes it becomes insignificant for CEO to make tradeoff between these two roles of members of the board of directors. It means management friendly boards are optimal (Michael S. Weisbach 1996). The CEO may hesitate while sharing information due to threat of intensive monitoring by an informed board. On the other hand he can also receive positive comments and can reveal his information in form of advice. Thats why the dual role of board of directors and its members is tougher. Sometimes the decision making lies only at board level so the information in that particular situation becomes necessary for which control system by board is tight a little bit. As board is a watch dog and represent shareholders while the CEO is management representative. CEO often prefers some different projects while the shareholders decide something else. So collaboration between these parties is much more
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necessary. Sometimes management has power to inject or expel any member of board, in this condition intensive control becomes insignificant and useless. Directors qualification and background also have impact on firm value. The technically strong and experienced board can judge and monitor environment more easily and can take quick decision at right time (Vidhi Chhaochharia and Yaniv Grinstein 2004). But it becomes difficult to choose the board members from the system which is partially in control of CEO. Then how can such boards monitor the performance of board members. The effectiveness board in seemed as independence of board. This creates agency problems (Benjamin and Weisbach 1996). So the governance rules and regulation becomes lifeblood for firm value. The whole system of corporate governance was when heavily criticized due to corporate failure of several firms in different parts of the world (Cadbury report 2000). The size and structure tell about the heavy costs of controlling. Different assumptions and variables are there which have direct and indirect influence upon the firm value. These may include board composition, tenor of the board, related party transaction, compensation plan for executives and sr. managers etc. upon the basis of these things various provisions and recommendations are evaluated majorly like Formation of accounting oversight board Independence of board Existence of various committees Evaluation of related party transactions Role of leadership in execution Accountability of top management Minorities representation in board of directors Injection of independent non executive directors Ethical values and business also Discouragement of family control of business All these provisions and recommendations are mandatory in several countries like USA, U.K and Europe but still not mandatory in many countries like Pakistan. In these countries these regulation and provisions are optional on the choice of firms (SECP 2002).
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Literature Review:
Lucian bebchuk and Alma Cohen (1991). They studied different regulatory provisions having impact on firm value and argued that majority requirements, amendments in charter and majority protection are positively correlated with firm value while other provisions are negatively correlated with firm value and reduce earnings and lower stock prices. Vidhi Chhaochharia and Yaniv Grinstein (2002).They stated that 2002 Governance Rules compliance intensity affected firm value both negatively and positively. Less compliance firms got positive abnormal profits and more compliant firms got negative abnormal returns. Muhammad Zakir Hussain, Muhammad Subhan and Shahida Sultana (2007). They collectively studied the corporate governance and firms business transaction with its affiliates and associates (Related Party Transactions). They argued that the Related Party Transaction are may lead to failure of some corporate bodies if undisclosed. They studied the banking system of Bangladesh. Adams Renee and Daniel Ferreira (2006). They studied that the Governance Rules placing high responsibility upon higher management especially C.E.O and C.F.O increased firm value by friendly boards (Board of directors) due to absence of conflict of interests. Benjamin E. Hermaline and Michael S. Weisbach (1996). They gave empirical study about monitoring the CEO. They stated that the boards should be selected as it should partially in the control of CEO and in hidden sights it can monitor the activities of CEO. They argued that boards effectiveness is actual ly its independence about the business affairs of the company. If CEOs bargaining power is less then board is considered independent and vice versa. Almazan Andres and Javier Suarez (2003). Argued that CEOs compensation and pay package has great impact on management performance. A healthy compensation package encourages CEO to take most active part to improve management effectiveness. Bengamin E. Hermalin and Michael S. Weisbach (1998). Both gave a fantastic view about the structure and composition of board of directors in a
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corporate body. They studied the determinants of board structure. They studied to finalize that CEO exit and firm performance have great impact on board structure and in case of CEO exit or Retirement Company tend to hire inside director by looking into future CEO. Anderson Kristen and Teri L. Yohn (2002). They gave empirical study of effect of 10-K restatements on firm value. They said that the investors react negatively to the accounting misleading and financial mistakes. But they response more to earning declining rather than general accounting mistakes and errors. Jay Dahya and John McConnell (2002). These peoples gave views about the relationship between company performance and top management turnover. They stated that the turnover rate increased as codes of governance applied and it affected the management performance positively. And it strengthened the codes of governance application and vice versa. Lucian A. Bebchuk and Jesse M. Fried (2003). They stated the executive compensation schemes and agency problems. They told that even with high compensation packages, agency problems arose. These could never be 100% eliminated. Stuart L. Gillen, Laura Starks and Jay C. Hartzell (2003). They provided information about the corporate governance structures and firms cost and benefits analysis. They evidenced that the corporate governance structures in context of cost and benefit analysis firm and industrial factors play equal role to examine the boards monitoring capabilities. Bengt Holmstrom and Steve S. Kaplan (2003). They critically studied the corporate governance system of USA in terms of rights and wrongs after enclosing of corporate scandals in USA. They viewed that there is a need of a better governance system inspit of high corporate earnings. Scandals in USA impacted to very lower extent but people and Govt. can react in future, so change is compulsory to look in overall system of corporate governance by public and state. Kenneth Lehn and Mengxin Zhao (2003). They studied the evolution of board size and structure with the passage of time. They told that the changes in board size and structure occurred with time. The size and structure firstly
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dependent on information of directors in the board but the growth opportunities and firm size is better determinant of board size and structure. Vidhi Chhaochharia and Yaniv Grinstein (2004). They studied the changes in board of directors and its characteristics and its connection with frauds. They argued that the minor changes in board characteristics have more connection and high changes in board have less connection with frauds. The advent of independent directors in board discouraged the fraudulent activities mostly.